1. Macroeconomic and Fiscal Consequences of Climate Changeand of Policies to Address it Michael Keen and Natalia Tamirisa April 11, 2008

2. 1 Presentation draws on: Presentation draws on: Chapter 4 of current World Economic OutlookChapter 4 of current World Economic Outlook Paper on Fiscal Implications of Climate ChangePaper on Fiscal Implications of Climate Change Both available at www. imf.org Both available at www. imf.org

3. 2 Outline The Economics of Climate ChangeThe Economics of Climate Change AdaptationAdaptation MitigationMitigation ConclusionsConclusions

4. The Economics of Climate Change

5. 4 Climate change is one of the worlds greatest collective action problemsClimate change is one of the worlds greatest collective action problems It is an externalityemitters of GHGs do not face the full social consequences of their actionsIt is an externalityemitters of GHGs do not face the full social consequences of their actions Economists have long prescribed corrective taxes to deal with thisEconomists have long prescribed corrective taxes to deal with this

6. 5 But climate change is a uniquely difficult externality: – Costs of mitigation come long before benefits (hence discount rate critical) – Uncertainty considerable – Possibility of catastrophic damages – Free-rider problem, requiring international cooperation…. – ….exacerbated by differences in countries vulnerability and historical (and prospective) responsibility

7. 6 increase in cost Climate sensitivity Future damages from climate change are uncertain, but could be large Major Factors Causing Variation in the Social Cost of Carbon Baseline Climate, Market Impacts, Risk of Catastrophe, and Nonmarket Impacts decrease in cost Percent Pure time preference rate for consumption Noneconomic impact Equity weight Climate change half-life Economic impact Central estimate 90% confidence interval Sources: Panel 1, Stern (2007); panel 2, Hope (2006).

8. 7 Damages are expected to fall disproportionally on emerging and developing economies India (with catastrophic risk) Africa Low income India (without catastrophic risk) Middle income High-income OPEC OECD (without catastrophic risk) OECD (with catastrophic risk) Japan United States Other high income Lower middle income China Transition economies Source: Nordhaus and Boyer (2000).

9. 8 Growth in emissions is driven by catching up economies United States Japan Western Europe Russia ChinaIndiaBrazil Source: International Energy Agency, World Energy Outlook (2007).

10. 9 Growth in emissions is driven by catching up economies Source: International Energy Agency, World Energy Outlook (2007).

11. 10 Growth in emissions in developing countries reflects economic development Sources: International Road Federation, World Road Statistics; World Bank, World Development Indicators; projections from Chamon, Mauro, and Okawa (2008).

12. 11 The share of non-OECD countries in the stock of emissions is projected to rise Sources: World Resources Institutes Earth Trends database and Energy Information Administration, International Energy Annual (2005).

13. 12 This is true of both energy-related and total emissions Sources: World Resources Institutes Earth Trends database and Energy Information Administration, International Energy Annual (2005).

14. Adaptation

15. 14 Much adaptation to slow moving climate change can and should be left to private sector…. But potential role for public sector, in – Climate-proofing public investments – Responding to additional spending needs, which (even with an expanded resource envelope) will require trade-offs with other development objectives – Dealing with climate change as a fiscal risk, through both self- and market insurance

16. 15 World Bank puts adaptation costs in tens of billions of dollars per annumbut much more needs to be known at country levelWorld Bank puts adaptation costs in tens of billions of dollars per annumbut much more needs to be known at country level Financial instruments also likely to play an increasingly important rolefor example, catastrophe bonds and weather derivativesFinancial instruments also likely to play an increasingly important rolefor example, catastrophe bonds and weather derivatives Good macroeconomic and structural policies can help facilitate adjustment to climate shocksGood macroeconomic and structural policies can help facilitate adjustment to climate shocks

17. Mitigation

18. 17 Classic prescription to deal with the externality is a carbon price, equal to the marginal social damage from emissionsClassic prescription to deal with the externality is a carbon price, equal to the marginal social damage from emissions Views differ greatly on the appropriate starting level: often $15-60 /tC (and Stern closer to $100)Views differ greatly on the appropriate starting level: often $15-60 /tC (and Stern closer to $100) But even more important is the expectation of a modest but sustained increase over timeBut even more important is the expectation of a modest but sustained increase over time Other policies (e.g., technology incentives and performance standards) also needed to deal with related market failuresOther policies (e.g., technology incentives and performance standards) also needed to deal with related market failures

19. 18 Carbon pricing can be achieved through either: 1. Carbon taxation, or 2. Cap and trade: allocate rights to emit, but allow them to be bought and sold, or 3. Hybrids combining elements of the above

20. 19 Which is better? Equivalent if abatement costs certain and permit rights sold…with additional revenue raised a source of benefit (though likely to be modest in most cases)Equivalent if abatement costs certain and permit rights sold…with additional revenue raised a source of benefit (though likely to be modest in most cases) If abatement costs uncertain, some preference for taxation (since getting emissions wrong over a short interval is not too costly)If abatement costs uncertain, some preference for taxation (since getting emissions wrong over a short interval is not too costly)

21. 20 What would mitigation measures of this kind mean for macroeconomic performance? WEO investigates this, using a global dynamic macroeconomic model (G-cubed, developed by Warwick McKibbin and Peter Wilcoxen)

22. 21 Global emissions are assumed to follow a hump- shaped profile, focus is on costs up to 2040 Global Emissions Targets and Paths, 1990–2100 (gigatons of carbon dioxide) Baseline path Target emission path for the world 2002 level 96% below baseline or 60% reduction from the 2002 level in 2100

23. 22 Emission and Carbon Price under Mitigation Policies Emissions (percent deviation from baseline) Carbon Price (US Dollar per tonne Carbon) United States Eastern Europe and Russia JapanOPECWestern EuropeChina Other developing and emerging economies

24. 23 NOTE: Output refers to gross national product, interest rate refers to 10-year real interest rate. For real effective exchange rate, a positive value is an appreciate relative to the baseline. Macroeconomic Effects of Mitigation Policies (percent deviation from baseline unless otherwise indicated) United States Eastern Europe and Russia JapanOPECWestern EuropeChina Other developing and emerging economies ConsumptionInvestment Current Account (percent of GDP; percentage points) Real Effect. Exchange Rate Interest Rate (percentage points) Output

25. 24 Consumption Loss (percent deviation from baseline) United States Eastern Europe and Russia JapanOPECWestern EuropeChina Other developing and emerging economies World Uniform Tax Cap and Trade, Initial Emissions- based Allocation Cap and Trade, Population-based Allocation

26. 25 Mitigation costs depend on countries efficiency in abatement, allocation of emission rights and policy design Total Costs of Mitigation, 2013–40 (percent deviation of consumptions net present value from the baseline) United States Japan Western Europe Eastern Europe and Russia China Other emerging and developing economies OPEC World, GNP- weighted World, population- weighted Uniform carbon tax and hybrid policy Cap-and-trade (by initial emission shares) Cap-and-trade (by population shares)

27. 26 Financial flows under cap-and-trade depend on how emissions rights are allocated across countries and countries efficiency in abatement United States Japan Western Europe Eastern Europe and Russia China Other emerging and developing economies OPEC By Initial Emissions Shares (percent of GDP) By Population Shares (percent of GDP) 2020 2030 2040 NOTE: A positive value denotes a receipt of transfersthe region is selling its emission rights.

28. Conclusions

29. 28 Quantitative results are model-specific…Quantitative results are model-specific… – Depend, among other things, on model structure, countries abatement costs and design of policies – Coverage of emissions (deforestation not included) But they illustrate importance of a few key economic principles:But they illustrate importance of a few key economic principles:

30. 29 Carbon pricing needs to beCarbon pricing needs to be – Long-term and credible – Broad-based – Common price for emissions – Flexible to accommodate changes in cyclical economic conditions and new scientific information – Equitable Supporting macroeconomic policies are needed:Supporting macroeconomic policies are needed: – Capital flows – Technology transfers – Managing transfers

31. 30 Drawing on environmental expertise of others, the Fund canDrawing on environmental expertise of others, the Fund can – Advise where effects of climate change are macroeconomically significant – Contribute to the wider debate